Investing more money in the future surprisingly has fewer benefits than investing small amounts incrementally over time. The principle is simple – the sooner you invest, the more time your money has to grow. Even with investing larger amounts later on, time still plays a bigger role in your portfolio’s returns.
The reason for this is two-fold. For one, your investments incur compound interest. Compound interest is the interest you earn on interest. For example, if you invest $1,000 and earn 7% interest last year, your portfolio is now valued at $1,070. If you earn another 7% this year, your portfolio would be worth $1,145. This is a $75 increase as opposed to $70. And this reason is due to compound interest. The 7% interest income is now based on $1,070 which includes your original investment and year 1 interest earnings.
The second reason you’re better off investing a little now opposed to a lot later is the time value of money (TVM). The TVM states that money today is worth more than money tomorrow. Let’s take an example.
Early Earl and Late Layla are both investors with different investing strategies. Early Earl starts investing earlier than Late Layla. Both have used financial planning services and decided they want to retire at 65.
At 25, Earl invests $100 per month in the stock market. After 10 years, he decides to stop contributing monthly and hold his money for another 30 years until he retires. Assuming an annual growth rate of 10%, Earl would have a nest egg of over $440,000!
On the other hand, Layla starts investing $200 per month at age 45. Given the same growth rate, Layla would have just over $150,000 by age 65.
But how? How can Layla invest double the amount and still end up with almost $300,000 less than Earl? Seeking investment advisory services will help you understand the intricate why’s and how’s to this question. But the simple answer is a combination of compound interest and the time value of money.
By investing early, Earl’s money had more time to compound and ultimately grow. The reason why the value of money is worth more today than tomorrow, i.e. the TVM concept, is because of the additional time it has to earn interest. This is why Earl had more nested than Layla, even though she invested double the monthly contribution Earl did. It’s unbelievable yet true that pure procrastination can cost you $300,000 or more!
Even though no one can predict the stock market, the S&P 500 has grown approximately 10% annually since its inception in 1928. Given this fact, there still will be times your investments lose value. This is the main reason why it is so important to diversify your portfolio. A healthy combination of stock, bond, and cash investments will help preserve your principal and mitigate against potential losses.
Krystal runs a full-service accounting and finance company, LYFE Accounting. LYFE Accounting is a one stop shop accounting company that services individual and business clients in all areas of their financial function including, but not limited to, bookkeeping, tax planning/tax preparation, CFO services, and personal financial planning. Krystal draws her research from experience as an international tax consultant, bookkeeper, and CPA for international multi-billion dollar companies to local and national small businesses.